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0:00
[APPLAUSE] ASWATH DOMODARAN: Thank you.
0:04
Thank you very much. I just posted, a couple of days ago, on where-- I actually am very lucky at the intersection of three different businesses. I'm a teacher first. I love to write, and I'm in finance. And the way I described it, I'm in three businesses that are all the begging to be disrupted, three really big, badly-run businesses, all of which need to be taken to the cleaners. So I've made it my objective at this point in my life to disrupt the businesses that I'm in.
0:38
And this is one of those acts of disruption. Because I think, for too long, we've thought about teaching as being classrooms in universities, but I don't see that restriction anymore. So what I'd like to talk about is actually what I've been teaching for 30 years. To give you some background, I came to NYU in 1986. And when I first came to NYU, they gave me a class to teach. It was called Security Analysis. And for those of you who know the history of that class,
1:04
it was a class than Ben Graham talked at Columbia in the 1950s, that you know who, he who shall not be named, took. And it's a class with a long and hoary traditions. So they handed it to me and said, you've got to teach this class. I took one look at the class and said, no way. This is the most boring piece or collection of topics I can think, because by the 1980s, it was showing its age. So I went to head of the department and said, I'd like to teach a Valuation class.
1:31
And he said, don't do it. There isn't enough stuff in valuation to actually teach a class. And you know what? In 1986, there wasn't enough stuff in Valuation. There were no books in valuation. In fact, when I did my MBA, which is way, way, way back in time-- 1979 through '81-- two years of the program, we spent about an hour and a half collectively on valuation. So I thought about it. And I said, I'd really to teach the class. And I considered two options.
1:57
One is to go the official route in the university, which is to ask officially for the class to be OKed. And if you've ever been in an academic setting, as most of you have how, you know how difficult it is to get things done officially at a university. A committee will be formed to report to another subcommittee. And by the time they get back to you, you'll ready to retire. So I discovered early on in my academic life, that if you want to get something done, its best to do it subversively.
2:24
So here's what I did. I said, OK, I'll teach the Security Analysis class. And I went into the classroom, and I taught a Valuation class. They have absolutely no idea what I do in the classroom. I mean, I could be teaching Cooking, for all they know. So you know how long it took them to find out? In 2008, I got a call from the dean's office. This is 22 years after I've been teaching this class. We've heard you're teaching a Valuation class. And I said, yes. I've been doing it for 22 years.
2:50
They said, we should call it Valuation. I said, welcome to reality. So if you look at the NYU schedule, you won't see Valuation until 2008. But that's because I've hijacked like six other classes in previous iterations and made them all Valuation classes. I'm fascinated by Valuation. But I'll tell you upfront what I think about valuation. I think valuation is simple. Fundamentally, anybody can do valuation. I think we choose to make it complex. Whose we? The people who practice valuation. Why?
3:22
Because that's how you make a living. You've got to cover things up with layers of complexity, keep people away. So I want to get back to basics. Obviously, in 40 minutes, I'm not going to cover the details of valuations. But I want to kind of hit some points that I think sometimes get missed, especially when people look at valuation from the outside. So here's the first message I want to deliver. Valuation is not accounting. And the reason I say that is, most people, if you say,
3:47
valuation, think numbers, think accounting statements, think income balance sheets. Valuation is not accounting. And it's actually a task I face every year I teach this class. In fact many of the MBAs that I teach come into my class in the first year in the spring semester. When they come in the spring semester, they've taken one class in accounting. And if you've looked at how MBA programs have evolved, MBA programs are very diverse now. I get museum directors. I get basketball players.
4:20
So to them, the only sense of finance they've had is the Accounting class. And part of my job is to get them out of the accounting mindset. So let me start off by explaining the way I see the difference between accountants look at the world and how finance looks at the world. Accounting is backward-looking-- nothing bad about that. So nothing I say should be viewed as bad. It's their job to record what's happened. So if you look at a balance sheet-- and most of you,
4:48
if you open up a 10-K or an annual report, will see a balance sheet. This is a classic accounting balance sheet. So let me look at the breakdown of how accountants break down a company. On the asset side, they break assets down into current assets-- basically, inventory, accounts receivable, cash; fixed assets-- land building equipment. Accountants are big on tangible fixed assets. For some reason, if they can see it, they're much more comfortable with it.
5:14
Then you have financial assets-- investments in other companies. And then you have what accountants euphemistically like to call intangible assets. Now, if I went around this room and asked people to name intangible assets, you'd see lots of things come to the surface-- brand name technology. But if you look at an accounting balance sheet, you know what the most common intangible asset is? AUDIENCE: Goodwill. ASWATH DOMODARAN: Goodwill. And let's be completely clear about this.
5:39
Goodwill is the most useless asset known to man. And here's why-- for goodwill to manifest itself in an accounting balance sheet, do you know what a company has to do? It has to acquire another company. So if you're the greatest company in the face of the Earth and you've grown entirely with internal investments, there will be no goodwill on your balance sheet-- period. The minute you do an acquisition, goodwill pops up. And here's why it pops up. You acquire a company.
6:09
It as a book value of $4 billion. So what do the accountants say, until just before you acquired it? It's worth $4 billion. It's worth $4 billion. You offer $10 billion. The accountant has a $6 billion problem to explain away, right. So you know what he does? He calls it goodwill. He puts it on the balance sheet. And he has to do it because the balance sheet has this very unpleasant requirement. It has to balance. Goodwill is a plug variable. The problem with Goodwill is it sounds good.
6:38
And when something sounds good, people feel the urge to pay for it. So every week, I get emails from people saying, I'm valuing this company. It has $5 billion in goodwill. How much should I pay for it? And my response is, it's a plug variable. What the heck are you doing paying for a plug variable? On the other side of the balance sheet, again, accountants get carried away. You have Current Liabilities, Accounts Payable, Supplier Credit, Deferred Taxes, so all kinds of stuff.
7:04
Then you've got long-term liabilities-- bank loans, corporate bonds. And then you have an item that's called Shareholders' Equity. If you get a chance, take Google, look at the balance sheet. There will be a Shareholders' Equity number. Take any company. There's a Shareholders' Equity number. You know what goes into it? Everything that's happened to this company over its lifetime. Think about it. When you look at the Shareholders' Equity for Coca
7:27
Cola, in that number is the original public offering that Coca Cola made-- which was what, 100 years ago-- and everything that's happened since. The Shareholders' Equity is a reflection of the past. So here's what I'm going to do first. I'm going to replace it with what I prefer to look at a company as-- a financial balance sheet. And at some level, a financial balance sheet is far simpler than an accounting balance sheet. At another level, it's far more complex.
7:55
Look at the asset side of the balance sheet, there are only two items-- Assets in Place and Growth Assets. Let's take the easier half of that. Assets in Place are investments you've already made as a company.
8:11
That's pretty straightforward, so value of investments you've already made. Pick any company you want. Think of the investments they've already made. Growth Assets is a little messier. It's a value I'm attaching to investments I expect you to make, next year, two years out, five years out, 10 years out, forever. I'm giving you credit for investment you haven't even thought about yet. That's pretty scary, right? An accountant can never do that. But I play by no rules, so if I feel
8:38
that you have great investments in the future, I can give you a large value. Let's look at a contrast. You look at Proctor & Gamble. Where's most of the value for the company coming from? Investments they've already made or Growth Assets. Most of the stuff they've already done is already on the ground. What else are they going to do? But if you look at LinkedIn and you can pick any young growth company-- and I'm not going to pick them in terms of quality. Just think of any young growth company.
9:07
On a good day, may be LinkedIn's assets in place are worth $1 billion, because they made about $10 million in operating income last year. You're paying $40 billion for the company. The extra $39 billion is for what? Expectations, perceptions hopes. Nothing wrong with it. But that's the first stop when you're an investor. You've got to stop and do a reality check. What are you buying, when you buy this company? Because the way you assess the company
9:34
is going to be very different, if it's Procter & Gamble, as opposed to LinkedIn. If you're Proctor & Gamble, you should be very focused on earnings reports and say, how much did they make last year. If you're LinkedIn, who cares what they made last year. That's why, when I see investors freak out over earnings reports from young companies-- and there are lots of them. Take any social media company. Look at how they freak out. Earnings per share were $0.02 below expectations.
9:59
I don't care, because the value of your company is not coming from what you did last year. It's coming from what I think you can do in the future. So when look at an earnings report for Twitter, I'm not looking at what did they do last year. I'm looking for clues as to is their growth potentially increasing or not. Are they doing the right things to create value from their growth assets? Most of the tools we have in finance were developed for mature companies--
10:27
PE Ratios, Return on Invested Capital, things you're taught in Business school. But if you have a growth company, you try to asses them using those tools. It's like using a hammer to do surgery. Think about it. That's going to be bloody, and it's going to come to a bad end. It doesn't work. So one interesting thing you can do when you sit with a businesses is take the accounting balance sheet and contrast with the financial balance sheet. The younger a company, the less you
10:56
will learn by looking at the accounting balance sheet, a for a simple reason. If you haven't been around long, the accountant has nothing to record. So if you look at a Twitter balance sheet or a LinkedIn balance sheet, there isn't much there yet. Doesn't make them a bad companies. It just makes the different. And on the other side of the balance sheet, you've got only two items-- debt and equity. There are only two ways you can fund a business. You can borrow the money, or use your own money.
11:22
You can slice this and dice this as much as you want. You can call them bonds and stocks. But every business has to have that choice. And guess what? You tell me where the bulk of your value comes from. I'll tell you whether you should be funding your business with debt or equity. And think why. Let's say, you're a young growth business. How young? You're an idea business. You're Snapchat-- no revenues yet, no earnings yet, plenty of potential. How should you fund your business?
11:51
What's the problem with borrowing money to fund an idea of business? Have you tried paying interest with ideas? Go to the banker and say, you know what. I have a lot of ideas. You can't make interest payments with ideas. If you're an idea business, this is Corporate Finance 101. Don't go looking for trouble. You have to raise equity. So that's the first message I wanted to deliver. Here's the second one.
12:21
I often see Valuation classed structured around spreadsheets. In fact, some of you might have sat in one of these classes by Training the Street. I like those guys. They come in with spreadsheets. They teach you how to be an Excel ninja. You can write macros on top of macros. You can do those shortcuts and turn columns into yellow, green, blue, et cetera. And at the end of two days, you are a master at Excel. And you think, this is what valuation is about, at the end of the process.
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in fact, the way I like to describe this is to step back and think about what drives the value of a company. If I'm asked to value a company, there are four basic questions to which I need answers. Here's the first one. You've already made those investments in the ground. What are the cash flows you're getting from those existing investments? Could be very small if you're a young growth company. But that's my starting point. That's why I look at the last financial statements,
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to get a measure of what your existing cash flows are. The second question I'm going to ask you is, what is the value that I see you creating with future growth. Notice how I phrased the question. I didn't ask you, what's your future growth. Growth, by itself, can be worth a lot, can be worth nothing, or can destroy value. Grow can be good, bad, or neutral, because you've got to pay for growth. So I'm going to ask, what's the value you create from future growth.
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Much more difficult to answer then, what are your cash flows for existing assets? But I need that answer. Third, I'm going to ask, how risky are these cash flows. Notice, I didn't throw in any terms to kind of buzz words you throw in there. What's a beta? Those are tools. Don't mistake tools for end games. I need a measure of risk. And I need to bring it into the value. And finally, I'm going to ask, when will your business be a mature business, because I've got to put
14:06
some closure on this process. I cannot keep estimating cash flows forever. So those are the four questions around which the valuation swivels, which then brings me to the way I think about valuation. When I start my Valuation class, which doesn't start until Monday, there'll be 200 people who walk into the class. And the first question I ask them is-- are your numbers people? Are you story people? Think about it for a moment. I bet, given where I am, that there are more numbers people
14:36
in this room than story people. And the reason I say that is, when I look at investing, you have two camps. You have the numbers people, who love to grind through numbers. It's all about the numbers. And it's the story people who like to be creative. They like story telling. The VC business is a storytelling business. I know, they throw numbers in, like the Target Rate of Return. But it's an after thought. It's a negotiating tool. It's a story game. And the problem right now is, the story people
15:06
think that the numbers people are all geeks. And the numbers people think that the story people are all crazy. And they can't talk to each other. In fact, sometimes, it's almost funny to sometimes watch two story people and two numbers people trying to talk about things. And they're talking right past each other. And here's the challenge I see myself having. When I come into that class and say, how many story people. How many numbers people? I ask them actually, in a very simple way,
15:35
to see which one you are, if you're not sure. I ask them-- how many of you enjoyed History in high school? You have 20 people-- I loved that class. Those are the story people. So how many of you preferred Algebra to History? That's the numbers people right there. And my end game for my Valuation class is to have numbers people with imagination and story people with discipline. That's the way to think about valuation. If you're a story person, I'm not going to stop you from telling stories.
16:04
Stories actually much more effective at selling business than numbers are. And it's been true for as long as human beings have been on the Earth. So if you tell a story, what I want to also bring in is enough numbers to discipline yourself. Because if you don't have the numbers, it's very easy to veer away into fantasy land. If you're a numbers person you have no imagination, you're not going to be able to do valuation because it's all about the numbers.
16:31
If you do a good evaluation, it should sing a tune. It should tell me a story. That's what I'm looking for. Behind the numbers, what is the story you're telling about a company? So when you look at the two groups, each believes they're the chosen people. The numbers people say, we're the chosen people. We have spreadsheets. We have numbers. We're on the right side of history. And the story people think, oh, you should listen to us. We have the great-- we are the creative people.
16:59
And I think they're both right, and they're both wrong. There's something to be gained from the other side. And to me, that is the key in doing valuation right. You've got to work with both sides of your brain. I don't even know whether it is mythology or not, that there's a left brain and right brain. But let's face it. Some of us prefer to work with numbers, and we have to force ourselves to think about stories. And some of us prefer to tell stories,
17:23
and we have to force ourselves to think about numbers. Think about your weaker side and work on it, because that's what's going to give you power in valuation. So when I do a valuation-- and I use a Discounted Cash Flow valuation. It's a tool. So when you hear DCF being used as a curse word-- and venture capitalists have used this on me. You're doing a DCF. And the way they say it, the contempt oozes out of them. You can't value this company using a DCF.
17:51
I think they're completely misunderstanding what a Discounted Cash Flow valuation is. Because ultimately, what am I saying? The value of your business is the present value of your expected cash flows from running this business. That's been true for as long as business has been around. We can debate as to whether we can estimate these cash flows. But don't tell me, cash flows don't matter, that it doesn't matter whether your company ever makes money. We heard that in the Dot-com era,
18:19
and look at how well that ended. It does matter how much you make. So when I think about a Discounted Cash Flow valuation, a Discounted Cash Flow valuation, to me, is just a tool to bring in answers to those four questions. My cash flows and existing essence feed into my base here. My value from growth gets fed in through the growth rate I use and how much I'm setting aside to get that growth. My risk is built in through the discount rate. And I bring it to closure, by assuming
18:45
that at some point in time, things settle down. And I can estimate the value of everything that happens after that with this big number at the end. But the DCF is not the end game. It's just a tool to convert your story into a number. So let me use a very simple example to kind illustrate this. I want to pick somebody who's never done a valuation before. And we're going to do some Valuation 101. Anybody who's never done a valuation before? OK, you can be my Guinea pig.
19:12
I can't move too far away, because I have to be on the camera. But this is an empty envelope. I'm not David Copperfield, no magic tricks. So here's what I'm going to do. I'm going to put a $20 bill. It's a little crumpled, but it's legal tender still. How much should you pay for this envelope? Don't think too long. That's what gets us in trouble. AUDIENCE: $20. ASWATH DOMODARAN: First rule in valuation, if you pay $20 for an envelope with $20, you get nothing. So let's try again.
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How much should you pay for this envelope? AUDIENCE: $10. ASWATH DOMODARAN: Go $1. You never know what disease I have. I might not be able to read numbers. First rule in valuation-- if you know the value of something, don't throw it on the table. You know the value of a company. Don't offer that value up front. Because then what do you have left for yourself? Put it in your back pocket, start really low, and then build up. But this is such a transparent asset value,
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that if I put it up for a bidding war, my guess is, by the end of the bidding, you'd probably get pretty close to $20. Now I'm going to make it interesting. What is this going card say? AUDIENCE: Control. ASWATH DOMODARAN: Control-- I'm going to put control into this envelope. How much should you pay for this envelope now? It's got control in it.
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You know what? I tried this in investment bank last week. In investment banks, you're trained. If you put a control into a company, there's a 20% premium. I don't know where that came from. The guy offered me $24. I sold it. He thought it was a game. I said, no, no, no, no, this is a real transaction. Pay me the $24. So guess what he'd done? He paid $4 for a three by five card that I stole from NYU, that cost me absolutely nothing. This is a money machine.
20:56
Now that I know you like to pay for three by five cards with nice sounding words, I can say, try more. What does it say? AUDIENCE: Synergy. ASWATH DOMODARAN: Synergy-- that's a big one. I'll throw that in there. That will probably go to $26.
21:10
What does this say? AUDIENCE: Brand name. ASWATH DOMODARAN: Brand name-- oh, that's a big one. That's $32 right now. And if that doesn't work, I have my two trump cards. What does this say? AUDIENCE: Strategic consideration. ASWATH DOMODARAN: Strategic-- that is the most dangerous word. When I hear the word, strategic, I'm running out of the door. Because you know what it means? The numbers don't fly, but I really, really, really want to do this. A strategic deal is a really stupid deal.
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But you really want to do this. A strategic buyer is a synonym for a stupid buyer-- a buyer who makes up his mind to buy something and then shows up at the table.
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And if nothing else works here is the trump card that always works. What does this say? AUDIENCE: China. ASWATH DOMODARAN: China. Just mention the word. It's amazing how common sense will leave through the other door. Take a look at earnings reports. Every company that reports it, even the most horrible, at the end they would say, but there's China. Nothing about China, but there's China. That alone doesn't it. They said, China. OK, we'll forget all of the facts.
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The fact that you've lost billions doesn't matter. You have China. I call these weapons of mass distraction. You know they come out because the numbers don't fly. In fact, I have a very simple test. When I read an analyst's report, I count the number of times these words show up. I have a list of a dozen. And the more times these words show up, the less substance there is to that report, because this it's what you use when you can't come up with a real reason for doing something.
22:45
So here's my first proposition. It's called the It Proposition. If it does not affect the cash flows and it does not affect risk, it cannot affect values. And what's it? Whatever it is controls synergy. I'm not saying, control doesn't have value. But if you tell me control has value, tell me what it's going to change. Maybe by controlling this company, you're going to run it differently, generating different cash flows, maybe by synergy, saying, my revenues will grow faster.
23:11
Let's talk about specifics. You can't let buzzwords drive decisions. Because if you let buzzwords drive decisions, you're going to make bad decisions. And worse, you're not going to plan to deliver those, because there's nothing behind them. The second proposition, I call the Duh proposition. I've named it after a subset of emails I get every week. And usually this is how the emails will go. I'm valuing a money-losing company. I expect it to lose money forever.
23:42
Which valuation model will work best in valuing this company. I feel like walking up to the person, slapping them around the face, saying, wake up. You're valuing a money-losing company. You expect to lose money forever. You're thinking about paying for this company. What's wrong with you? Which brings me to the third and final proposition-- next week, when my class starts, I let people pick companies. In fact, I insist that they pick companies.
24:05
They have to value those companies over the next 14 or 15 weeks, over the semester. They can pick whatever company they want. They can pick Lukoil. They can pick Google. They can pick Amazon. And sometime in the first or the second week, a subset of people-- not everybody in the class, thank god-- but 10 of them will show up saying, I have to change my company. I say, it's a little early. Why are you panicking? They say, well, I worked out the cash flows for my company. And they're negative.
24:31
And you said in the Duh proposition, if the cash flows are negative, you can't value a company. And I say, that's not what I said. If the cash flows are negative forever, you can't value the company. But if your cash flows are negative in year one, year two, year three, it's not the end of the world. In fact, there are a subset of companies, when you value the company, you should get negative cash flows up front. What types of companies will you get negative cash flows up front?
24:54
AUDIENCE: Growth companies. ASWATH DOMODARAN: Young growth companies-- and here's why. To grow, what do you have to do? You've got to put money back into the business. There is no magic bullet that you can use to grow at 80% a year. So if I'm valuing a Tesla, I should expect to see negative cash flows up front. Why? Because you've got to build those assembly plants to deliver those 10 times more cars I expect you to sell five years from now. But if you have negative cash flows upfront,
25:21
you've got to have disproportionately large positive cash flows in the future. You see why they have to be disproportionately large? You use $1 billion in year one. You've got to make up for it with $10 billion in year 10. So with young growth companies, that's exactly what you should expect to see. You should see negative cash flows up front, because that's what you need to grow the company. And as a company matures, Nirvana shows up. Cash flows turn positive. You get the big values.
25:48
But that's OK. So here one way to think about the search for valuation. You sit down to value a company. You pull up the financials-- annual report, 10-K, 10-Q. That will give you a sense all of what this company did last year. And if you have a mature company, that might be all you need. Because they're so set in their path, that you can pretty much value the company using last year's financials. But if you have a company that's in transition and market that's
26:17
changing, you have to collect information about how the market is evolving, who the competitors are. When you think about risk, you're going to look at the past. You're going to look at the future. You're going to be looking at every piece of information. And my only suggestion if you value new businesses-- don't do a blind Google search. You know what mean? So if you say-- For instance, I have to value Uber. If I type in Uber in Google, you know what I get? Everything ever said about Google
26:43
on the face of the Earth. When you search, you want focused searches. In other words, you first figure out what you're looking for. And then you go looking for it. In fact, what I do is, I open up an Excel spreadsheet with the inputs I need. And with each one, I say, this is the number I'm looking for right now. I'm not going to get distracted, even if I find something interesting about something else, for the moment. I'm going to stay focused on-- so
27:05
if I'm looking at the risk in a company, that's all I'm looking for. Are there any clues I can get by looking at the company, the market, and the competitors, about that risk? And at the end of the process, I'm keeping my eyes on the prize. This is not about getting more information. It's about taking data and converting into information. We live in a world where we have too much date. That's the reality we face. Our job is to take the data and compress it
27:31
into information that actually shows up in our valuations. So here's a simple example of a valuation of a very boring company. We all know what 3M does, right? Incredibly sophisticated stuff like the Post-It note, but don't laugh. It's an incredibly profitable product. It's a company with a long history. And this is a valuation I did of 3M in what I call the days of innocence. Those are the days when they were developed markets on one side and emerging markets on the other.
28:01
And never the twain shall meet-- pre-2008. So it's a mature company, in what I thought was a mature market. In hindsight, I was hopelessly wrong. But my point is, in valuing 3M, I had to make estimates. But those estimates were easy to make. Why? Because there was a lot of history I could use. I knew what their business model was. I didn't have to figure out what they would do in the future. So it's a valuation that was centered. There was uncertainty, but the uncertainty was much smaller.
28:30
The way to think about it-- if you think about narrative and numbers, in the case of 3M, the story is almost done. You're in chapter 33.
28:39
There's not much room for you to change the story. You can't go back and rewrite the story. So this is a valuation that you could do almost on autopilot. And this is the kind of company that you're taught to value in a Valuation class in school. And I have some really bad news for you. If this is the kind of company you can value, anybody can value these companies. in fact, I'm not even sure you need a body. In fact, how many of you have an Apple device? Or is that not allowed in Google?
29:09
If you have an Apple device, go to the iTunes store and type in uValue. It's an app that I co-developed with a friend of mine, Anand Sundaram at Dartmouth, that does valuation. So you download it. You plug-in the numbers. If your flight is 30 minutes delayed, you have nothing to do. You're one of those freakish people who likes to work with numbers. You put in nine numbers. You value a company. You move on. And I wrote it because I wanted to disrupt this valuation business.
29:34
Because so much of what you pay for in valuation is a banker feeding in numbers into something like that and then spending 25 days making it look like he did a lot of other stuff and then charging you millions of dollars for something he has no business charging you millions for. So if you're valuing 3M or companies like that, you don't need an appraiser. You don't need a banker. Anybody should be able to value those companies. But let's talk about more interesting companies.
30:02
This is a valuation I did of Apple in March of 2013. I've actually valued Apple every three months forever. But since 2010, I've been public about my valuations. What I mean by that is, on my blog-- which is a Google blog, so that a good think about it-- I post my valuation of Apple, because I don't believe in hype-- The way I describe it is, I'd rather be transparently wrong than opaquely right. And in this business, people want to be opaquely right. What I mean by that is, they will
30:35
say things that are so difficult for you to construe, that no matter what happens, they can say, I told you so. And it drives me crazy. So what I do is, I say, this is what I think the value of Apple is. And of course, I'm going to be wrong. But at least you can see where I went wrong. So this is a valuation I did of Apple in March, 2013. Because every time a new earnings report comes out, I re-value the company. So I'm due for one very soon, because Apple's earnings
31:03
reports just came out last week. What I'm trying to illustrate here though is, in traditional valuation, here's how you value a company. You making best case. Basically, not even best case, you make your expected value estimates for things like cash flows and growth and risk. point estimates. So I ask you what the growth is. You give me a number. You ask me what the risk is. You give me a number. But the reality, if you think about it, is, you face uncertainty.
31:31
You have a distribution in your head, and I'm forcing you to give me a number. And part of you is saying, it's 8%, but it could be 3%. It could be 11%. And 25 years ago, I can see why you were stuck. You had to do that, because we did not have the tools to actually bring in uncertainty. I actually have Crystal Ball attached to my Excel. If any of you use Crystal Ball, it's a simulation add-on to Excel. And what it allows you to do is enter a distribution for your assumptions,
31:58
rather than a single number. So if I'm writing a company like Apple, rather than give one number, I can give you a distribution. So rather than say, revenue growth is 6%, I can say, it's uniformly distributed between 3% and 9%. And the more uncertainty you feel, the wider the distribution is going to be. And if any of you have done a simulation, here's what happens. The computer goes and picks one outcome of each simulation and does a valuation. Crystal Ball's default is 100,000 simulations.
32:25
This is what my simulated value for Apple was in March of 2013. What is that? How does that help me? The stock price was $450. In my base case valuation, I got about $580. So I could give you the base case value and say, I think Apple is undervalued. But your defense will be, but you could be wrong. Of course, I could be wrong. But what the distribution shows you is how wrong I can be. And if I'm a decision-maker, I'd much rather base it on a richer set of information.
32:54
Because here's what I can tell you about Apple-- I can give you an expected value, like I did before. I can also tell you, if you pay $450, what the chance you are wrong upfront is. I can give you an ex ante probability. There's a 21% chance you could be wrong. All I have to do is count the number of values below $450. And I put up a distribution. And in March of 2013, based on my valuation, I said, I know I can be hopelessly wrong on my inputs. But based on the outcomes, it looks
33:25
like there's a 90% chance-- you see where the 90% comes from? The 10th percentile is about $450. The stock is trading at $450. Investing is a game of odds. And it looks to me, based on my assessments, that the odds are in my favor. And of course, this is an investment that's worked out hopelessly well, in some cases. Hopelessly, well because the stock is now what? $840, with the seven to one split. Not everything works out that well. But what I'm trying to say is, don't let uncertainty stop you.
33:57
And especially in the technology business, I find this defense to be very troubling. You ask people, why are you not valuing this company? Because there's too much uncertainty. What does that mean? Your estimates could be wrong, but that doesn't mean you can't make an estimate. Saying that this too much uncertainty to do a valuation and then investing in the company, to me, is the height of insanity. And lots of venture capitalists go through that cycle over and over again.
34:27
They say, I don't want to value the company, but I'll invest in the company. You can't tell me one thing and do the other. So if you cannot value the company, at least do the logical thing and never invest in those companies. But if you want to invest in young growth companies, you have to get your hands around those numbers and make your best estimates. Now, of course, with a young startup, all these questions become more difficult to answer. In you're the founder of a young startup,
34:52
let me ask you the four questions to which I need answers. And you're going to see why life is so much more difficult. First question-- what are you cash flows from existing assets? You're a young startup. What the answer to the question? What assets? I have nothing. I'm sitting on a chair. I don't even own it. OK, that was easy. Then I ask you, how much value do you think future growth will bring in? You say, a lot. I say, can you be a little more specific?
35:16
Not really-- I don't even have a business model yet. I say, how risky are you? Very. But you can't give me past prices and earnings, because you haven't been around. I say, when will you be a mature company? And you fall on the ground laughing. You might not even make it through tomorrow. Every question becomes like pulling teeth. And that's why, with young startups, people give up. My suggestion is, rather than give up, make your best estimates.
35:42
Don't put the weight of the world on your shoulders, saying, I have to be right. You cannot be right, but you can still make estimates. For the last four years, every time you've had a big IPO come up, the week before the IPO, I've tried to value the IPO. The reason I do it the week before the IPO is, if you wait until the IPO is priced, that number starts gnawing away at your brain. So when you do a valuation, your number starts to wander toward that number.
36:07
So this is actually a valuation I did of Twitter, the week before their IPO. So what triggered this was, I was on CNBC. So once in awhile, I end up in that insanity. And I was actually-- we were talking about Twitter. And there's an analyst there who was very optimistic about Twitter. So I said, why do you think Twitter is worth so much? He thought it was about $65 or $70 per share. He said, because the online advertising business is huge. So I said, how big is the online advertising business?
36:37
He said, I don't know, but it's huge. This is exactly what gets us into trouble. People don't want to talk-- it's like China. Online, it's huge. And because it's huge, I can pay whatever I want. So I said, you know what? If I want to value Twitter, that's where I need to start. I need to figure out how big this business is. Doesn't take a whole lot of research to figure this out. But the entire online advertising business in 2013 was about $120 billion.
37:04
That's the whole global online advertising business. The biggest player, by far, is Google. And if you look at the breakdown, you can see, Google is about 33% of the global online advertising. The next biggest is Facebook, and then you have a splintered business. So that's the business right now. I do know that online advertising is becoming a larger and larger portion of overall advertising. Print media is going out of style. So here's what I had to do first, to value Twitter.
37:34
I had to figure out how big this market was going to be. Because before I talk about what the revenues for Twitter are going to be, I need to figure out what they're aiming for. So I make some assumptions. I assume that the overall advertising market is about $550 billion. So about 20% of all advertising is online right now. But the overall advertising market can growing about 3% a year, because it's an expense to companies. They can't grow at 10% a year. But online advertising would increase
38:02
as a percentage of that to become about 40% of the market. That gave me my endgame. It give me my online advertising market a decade from now. It's about $200 billion. AUDIENCE: How did you figure 40%? ASWATH DOMODARAN: I made it up. And I made it up on the following basis-- I looked at how quickly existing advertising media revenues are dropping. Print advertising is falling through the floor. But TV advertising has actually been surprisingly robust. So there are certain kinds of advertising
38:34
where I think you're going to see other advertising. Billboard advertising is not going to go away. Because if you're driving, it's tough to have online ads. Maybe you'll figure something out. But you'll have a lot of accidents. So I made that assumption. Clearly, that's where you and I can have different values for Twitter. But at least we're talking about substance. So if you made a stand saying, I think it's going to be 60% of the market, OK. So you have to go marshal the ammunition for that.
39:00
So I use 40%. And then I had to make a judgment as to what percentage of that market Twitter would capture. That's tough. You've all seen how Twitter ads work, right? It's that sponsored Tweet that shows up-- pisses me off, no end. I've never clicked on a sponsored Tweet. I hope nobody ever does. But that's the way they make their advertising revenues. And that's their strength and their weakness. Their strength is 140 characters. Their weakness is 140 characters.
39:29
That's a strength, because it makes it nice, compact. The weakness is, it can't be your primary advertising. So the way I see it is, even if Twitter succeeds, it'll never be Google or a Facebook. It'll be a lesser player. And that led me to use a market share of about 6% for Twitter, which is still about $12 billion. Here's a company with a half a billion dollars in revenues right now. And over the next decade, I'm assuming it's going to go 24-fold to $12 billion. So that gave me half the game.
39:58
I then have to figure out how much money they will make once they're past this growth phase. And there are two big targets here. One is Google, and the other is Facebook. Both are immensely profitable. Google's margins are about 22% of revenues. Facebook's are about 30%. And Facebook's margins are dropping, each year that you watch them. Because as they get bigger, it's tougher and tougher to maintain-- these are immense margins. But I thought I was being optimistic, when I used
40:27
a 25% end margin for Twitter. I said, that's what you're shooting for. So I've got my revenues in year 10. I've got my margins in year 10. I also had to bring in that final piece, which is, this isn't going to happen by magic. You're not going to go from half a billion in revenues to $12 billion, without doing something. So I had to estimate how much they would have to put back into the business, in acquisitions, new technology. That's a reinvestment I'm getting.
40:53
And I'm computing it based on how much their revenues are changing each year. Those three pieces give me my cash flows. The small revenues become big revenues. The losses become profits. The reinvestment gives them the engine to drive the revenue growth. That's what I spent the bulk of my time on. Most people who do this kind of cash flow valuation, there are two parts to DCF, Discounted Cash Flow valuation. There's the D and the CF. The D is the discount rate.
41:19
Here's my problem with the way DCFs are done. 80% of the time that most analysts spend is on the D. They'll finesse it to the nth decimal point. 20% is on cash flow. I'll make a confession. The Twitter valuation, 97% of the time that I spent was on the cash flow, and towards the end, said, I need a discount rate. And for the discount rate, what I effectively used a discount rate of about 11%. And I didn't think about it too much. 11% puts you in the 95th percentile of US companies.
41:53
So I'm basically saying, they're a really risky company. I could finish this a little more. But I really don't care. This is really the small stuff. My bigger assumption is what my revenues will be, what my margins will be. This is not where I'm going to screw up. And I always have to factor in that with a young company, there's a chance that they would not make it. In the case of Twitter, I assume that there was zero chance that they would not make it, because they have access to capital.
42:15
It's not that they won't screw up. But they seem to have access to people who keep giving them money, even if they screw up. And that's a nice skill to have. Those are the things that fed into my valuation of Twitter. And in the week before the IPO, the value that I put was $18. And if you remember your history, it was priced at $26. And on the offering day, it didn't even open for about two hours. And when it did open, it opened at $46. And I got a call from somebody saying,
42:46
how do you explain the $46. And I said, I don't have to. I didn't pay it. I've never felt the urge to explain what some other person pays. AUDIENCE: What was your final valuation? ASWATH DOMODARAN: $18 per share? Yeah. So I get calls saying, how do you explain Uber's $41 billion. Ask somebody who paid the $41 billion. I didn't do it. I just take Uber once in awhile. But I'm not big $41 billion to my driver. So I don't feel the urge to try to explain it.
43:12
In fact, that's one final thing I want to say. Much of what you see passing for valuation out there's is really pricing. If you have no idea what I'm talking about, let me give you a couple of very simple tests. How many of you own a house or an apartment? What, Google doesn't pay you enough to buy your own apartment? Time to raise your salary, so I'll make sure that happens. You know how this works. What do you do? You hire a realtor. The realtor shows you a house.
43:40
I'm thinking of moving to La Jolla, especially after two winters like-- I'm done. 28 winter in New York, I'm out of here. My wife is from California. I'm going back. I went to UCLA. I can't take this anymore. So I talked to my wife. And the minute I said it, she's checking out houses. Hey, this is a good thing. And she picks the most expensive part of California to look-- La Jolla. This is a slum in La Jolla. It's less than $1 million. That shows it's one of the cheapest houses probably
44:08
in La Jolla. But here's my question. How did the realtor come up with that $995,000 for the house? How does a realtor come up with the number for an apartment. What does he or she do? She looks at other apartments. Or he looks at other units that sold in the neighborhood, adjusts for the fact that you have an extra bedroom or a bigger lot. It's pricing There's no valuation going on. You think, those unsophisticated realtors. Let me show you a second. You've seen an equity research report?
44:36
If you haven't, save yourself the trouble, because here's what the analyst will do. There will be a company name. There will be a multiple, which is like a standardized price, like a price per square foot, a price earnings ratio. There will be 15 other companies that the analyst claims are just like your company. In what universe, I don't know. I've seen Google Equity Research reports. These 15 companies are just like Google. Oh really? That's amazing. How do you find those?
45:03
I would argue that the realtor was on much firmer ground, looking at apartments around the neighborhood, than an Equity Research Analyst trying to find 15 companies like Google. But that's exactly what the Equity Research Analyst is doing-- pricing your company, based on what comparable companies traded, though there's nothing comparable about them. You're saying, those unsophisticated Equity Research Analysts. You sometimes see a discounted-- this looks like one of those discounted--
45:32
if you pay a banker, this is what you get-- cash flows. The next time you see a valuation from a banker, zero in on the biggest number in the Discounted Cash Flow valuation. It's always the end number, the value at the end of your file. Take a look at where that number comes from. And I'll wager, in nine out of 10 banking valuations, that number comes from applying a multiple to year five number. What do I mean by that? In this case, here's what I did.
45:59
I took the operating income in year five and multiplied by 10. Why 10? Because that's what other companies trade at right now. I can tell you all kinds of stories, but this is a pricing as well. I'm just hiding it in year five. I call these pricing in drag. The drag component is the cash flows. While you're distracted by the cash flows, you slip in 10 times. That's what's driving this number. Most of what passes for valuation out there is pricing. You're saying, so what.
46:29
It's a very different game. What sets prices? It's demand and supply, mood and moment. What's sets value? Cash flows, growth, and risk. Could the two give you different answers? Absolutely. If you are trader-- not a traitor, but a trader-- you care about prices. What's CNBC? CNBC is an instrument for trade. You are trading the stock. All you care about is what moves prices. So the only question I'm asking is, what's the mood. What's the momentum? Where's it going?
47:01
So if you ask me to explain why people are paying $41 billion for Uber, you know why? Because they think they can sell for $75 billion. That's basically it-- that they think that they can take it in a public offering for $75 billion. Are they right? If the momentum continues, they could very well be right. Does that mean that Uber has a value of $75 billion? That's a very different question. Sometimes price and value can diverge. And if they diverge, they can give you very different numbers.
47:33
The social media space is a pricing space. In fact, if you ask me why social media companies trade at what they do, I have a very simple answer. It's not because how much they made in revenues. It's not because how much money they make. Thank god for that, because most of them make no money. So here's what I did. I decided to let the data tell me what drove the pricing. And here's what I did to answer the question. I took every social media company.
47:57
It's easy to get the public information, what the market value is. And then I collected all the information I could about these companies-- what they had in revenues, what they had in earnings. What I was trying to figure out is, how is the market pricing these companies. What is it using to come up with the prices? And I drew on statistics to answer that. All I did was a correlation between the market cap and different variables, to see which one had the highest correlation with the market.
48:23
So what is it that makes some social media companies valuable and the others not? And you could look across the correlations. And by far-- look at the correlation. The most critical variable in explaining the market value of a social media company is the number of users. I'll give you a very simple way to value social media company. Here again, you can save yourself the trouble of hiring a banker. You tell me how many users you have. If you go back to the previous page,
48:51
the market is paying about $100 per user. You tell me how many users you have. I'll tell you what your value is going to be in the company. So how many users does Twitter have? 250 million. 250 million times 100 is $25 billion. We're done. Who cares about cash flows, growth, and risk? Facebook is 175 billion users, million users. They wish they had 175 billion. What planets are you going onto?
49:19
1.75 billion users-- you multiply that by 100. You get $175 billion. And remember last year when Facebook bought WhatsApp? How many of you have WhatsApp on your phones? How many of you pay for your WhatsApp? That settles my case, like one in five people. In fact, last year, when they bought WhatsApp, the paid $20 billion for the company. $19 billion seems to have rounded up to 21. Don't ask me how those things happen. It's just a couple of billions anyway.
49:46
I got a call again, saying, how do you-- for some reason, people think I have to explain what other people do. How do you explain what Facebook just did? And I said, you're missing the point. Facebook is not buying WhatsApp for the earnings, the cash flows and the revenues. What are they doing? AUDIENCE: The users. ASWATH DOMODARAN: How many users did WhatsApp have? Like 400 million. Even if you allow for the fact that about 80 or 100 million of those are already Facebook users,
50:10
you're buying 300 million new users. if the market is paying $100 per user. 300 million times 100 is 30 billion. You're getting a bargain. Don't laugh. This game is going crazy right now. People are buying users, because that's what the market is rewarding. You're saying, what's wrong with that. Markets are fickle. Today, they like users. Tomorrow, they might not. Remember, they liked website visitors for a long time? But they said, you know what? I can't pay dividends with website visitors.
50:41
It's kind of tough to say, I'll take three visitors, please. Send them to my house. They'll work around. I paid a lot of money for your stock. At some point, they're going to ask for substance. And the way I describe social media companies-- it's like having a gigantic store with nothing on the shelves and lots of foot traffic. That's you're buying. What are you hoping for? That if you put something on the shelves, maybe they'll stop and buy it. It's not an unreal exercise.
51:06
Call it a field of dreams. Remember, Kevin Costner, "if we build it, he will come," Shoeless Joe. It's the same thing. If we have the users, it will come. How it will come, I don't know. But it will come. But that's what pricing is about. It's not about what you and I think matters. It's what the market is building in, which brings me to my last point. And I hate to be the one to break this. This is a game where luck is the dominant paradigm. When I say, this, I'm talking about investing--
51:41
venture capital investing, regular investing. We like to think it's skill and hard work. It's luck. If you're lucky, you can do a horribly sloppy things and be incredibly rich. If you're not, it doesn't matter how well you do things. You're still going to lose money. If you're lucky, all else is forgiven. And all too often, when people make money, they like to claim it's skill. For a while, the hedge fund managers were saying this. We're skillful guys. We're the smartest people in the room.
52:10
Says who? When people talk about smart money, I always cringe. There is no smart money. There's less stupid money and more stupid money. But there's really not smart money. And in fact, the best evidence that there is no smart money in hedge funds is what's happened collectively to the hedge fund business. You know how hedge funds work, right? First, they take 2% of your money up front. Then they take 20% of whatever your upside is. It's a horrendously bad set up.
52:42
But you do it because you're greedy. You think they can deliver more than the market. Collectively, hedge funds deliver about one percentage point less than what you could make by putting your money in an S&P 500 Index fund. It's a strange business. I can't think of-- the analogy would be starting a plumbing business called Floods R Us. And here's what you do. There's a leak in your house. You call me, and I leave a flood. You would never call me back.
53:07
That's what we do collectively with these hedge funds. We pay them tons of money to do what? Earn less than what we could have made by not paying them. You figure it out, because I certainly can't. So here's my final point about valuation. It's one of my favorite movies of all the time, "The Wizard of Oz." Remember the story? Dorothy gets sucked out of Kansas. She gets dumped in Oz. She wants to go back to Kansas. Don't ask me why. I'd have stayed in Oz.
53:35
So of course, the move starts with, I need to go back. And of course, she's given the classic advice. Go meet the Wizard of Oz. He has all the answers. The entire movie is about her going on the yellow brick road and this motley crew of characters she collects-- the Scarecrow who needs this and then Tin Man, the Lion. And they all get to Oz, expecting the wizard to be this all powerful person, who grants-- They walk into the chamber. They each tell the wizard what they want.
54:02
And the wizard has this deep voice, until the curtain drops. And you realize it's a small guy behind the curtain who's been pulling-- there's really no Wizard of Oz. But it turns out that they all got what they needed, during the course of the journey. You say, what's this got to do with valuation? I firmly believe that you learn valuation by doing. You really want to learn valuation. Here's what you need to do. Value a company. The first time you do it, it will be like pulling teeth.
54:31
Then value another company, as different from the first company as you get. So next week, I'm putting up a valuation. It's a crowd valuation of Uber post that I did on my website. At each stage, I ask you to decide what Uber is. Is it a car-service company or a transportation company? Is it a local networking benefit or a global networking benefit? I can tell you my story. And at the end of the process, say, based on your story, this is Uber's value. And the value for Uber ranges anywhere
54:58
from $800 million to $95 billion, depending on the story you tell. When we get big differences in value, it's not because the numbers are different. It's because we have different narratives. Not all of these narratives are equally likely. And that's really the question you've got to ask. It's, what is the right narrative for my company? I promised I would not talk about Google. But I will leave you with this thought. If you're thinking about Google as a company going forward,
55:23
as an investor, here's the question I'm asking. What is the narrative I'm telling about this company? What do I see this company doing? Because that's what's going to drive the valuation of Google, not the fact that because of exchange rate movements, you did not deliver the growth. Who cares? In the larger scheme of things, those things don't change your narrative. If investors react to it, let them react to it. This is about telling a story and delivering
55:47
the kinds of decisions that back up that story. That's about it. Thank you very much for listening. If you have any questions, I have a couple of minutes to answer the questions. Yes. [APPLAUSE] AUDIENCE: I was wondering. You had these graphs with distributions on what your valuations are. Have you done an analysis of how accurate the distribution is, compared to-- ASWATH DOMODARAN: How would you do it? It's like nailing Jello to a wall. And here's what I mean by that. It's a very noisy process.
56:24
This is a distribution at a point in time. If I move forward a month and I redo the distribution, the entire distribution will shift. It's really not about the distribution of value. It's about value versus price. So what you can look at is, if you're right about values, the price moving towards a value. In the case of Apple, it turned out that it did. But it's a sample of one. So it's almost an article of faith. If you're an investor, you believe that ultimately price moves towards value.
56:53
There's no guarantee that it will. So if you do your job. You collect the information. You make your best judgment. You estimate a value in a distribution, and you decide, based on it, to buy something. What you're checking to see is not whether the value gets delivered, but whether the price moves towards the value. And I believe it does. And that's why I stick with it. But it's a fact-based process. If it doesn't work, you need to let it go. Yes? AUDIENCE: Was it ever proven that price
57:19
moves over the value? ASWATH DOMODARAN: Again, ultimately, there's a reality here, which is businesses-- perception is fine. If you're valuing a Picasso, or pricing a Picasso, it's all perception. If tomorrow we all woke up and said, the guy can't paint. He's got a nose in the wrong place. But a business can't be all perception. So price can deviate from value for extended periods. It's not a question of whether it moves the value. It's when it does. And that's really the debate.
57:53
There are some people who say, it takes so long to happen, that there's no point even waiting for it. Those are the traders. They say, well look, I'm going to make money in the next. If your time horizon is six months, don't even waste your time thinking about value. You have to play the pricing game. So it's almost a given, when you play the investor game, that you have a longer time, or else. Yes. AUDIENCE: So a Google, a lot of times,
58:17
our valuation is first, because we're making an acquisition. How do you mix in the cost of bringing this whole team on board. And how to you incorporate that into the valuation? ASWATH DOMODARAN: Well, I think, at the right-- I'll tell you what I think about acquisitions in general, rather than speak about Google. At the right price, I don't care who you buy. At the wrong price, I don't care who you buy. Basically, at the right price, you can buy the worst possible target.
58:42
And you're going to come out ahead. At the wrong price, you can do everything right, but you're already screwed.
58:49
In acquisitions, the problem I see is that we spend too much time on finding the right target and doing all that neat stuff where we fit stuff, and too little time asking, what are we paying for that. You're right. After the acquisition, there's all that post-acquisition work you have to do, to deliver, especially if you're talking about synergy, because that's often what drives your acquisitions or whatever additional value it creates. So that requires that you take the strengths
59:16
of the company you've acquired and add it onto your strengths, to deliver it. That requires work. And that's, I think, the bottom line. It's not going to happen magically. And that's why I prefer that it be done before the acquisition, that you start putting plans down of what you're going to do, before the acquisition, rather than wait after the fact, and say, oh my god. This is not going to work. So if you've got an acquisition process. It's got to be disciplined.
59:39
And it will work only if you're willing to walk away from the table, even if it was the best target you've ever found, but the price is too high. If you're never willing to walk away from the table, you are going to overpay, over and over again. And in too many big companies, the problem I see is that the company decides it's going to do an acquisition and then goes to the bargaining table. You're in terrible position to bargain, if you've already decided you're going to do this.
1:00:06
Last question, then I'm going to stop. AUDIENCE: I have a question. ASWATH DOMODARAN: Go ahead. AUDIENCE: So I was curious. What is your take on an individual investor, people like us, who have full-time jobs? And a lot of us are not MBAs and not students of valuations. And the traditional, conventional advice is to buy at index point. I was just curious. Do you endorse that? Or for someone who's interested in learning, what do you recommend? ASWATH DOMODARAN: Well, investing takes work.
1:00:40
And if you don't have the time for that work, it's probably best not to put yourself at risk by doing something because you heard somebody say it. So my suggestion is, go with the low-time-intensive investment strategy. It doesn't always have to be an index fund. It Has to be some kind of-- you've got to spread your bets and don't overreach. You don't get rich by investing. You get rich by doing whatever you're doing. And investing is about preserving what you made elsewhere and growing it.
1:01:09
It's when you get greedy about trying to make that killing on your investment that you tend to overreach. So I have to stop there. Unfortunately, I have a 4:18 train. I wish this were not true. I'd have normally stayed until 5 o'clock. So thank you very much for listening. [APPLAUSE]
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